Reverse-engineering the MMT model

I'm trying to keep this as simple as possible, so it's accessible to second-year economics undergraduates.

Many theoretical papers I read are full of impenetrable (to me) thickets of math. So I reverse-engineer the model. I try to figure out what the underlying model must be in order for the paper's conclusions to make sense.

Many Modern Monetary Theory posts I read are full of impenetrable (to me) thickets of words. So I have reverse-engineered the model (with the help of Steve Randy Waldman's blog post and Scott Fullwiler in comments on that post). I think I have figured out what the underlying model must be in order for MMT's conclusions to make sense.

I don't think my model is a straw man. It is a stick-figure. A very simple caricature that shows only the bare bones, but is still recognisable.

Start with the standard textbook ISLM model:

In the background, off-camera, is a Phillips Curve. The Long Run Phillips Curve is vertical, at the natural rate of unemployment. Yn represents the natural rate of output associated with the natural rate of unemployment. It is sometimes (misleadingly) called "full-employment output".

Where the IS curve crosses the vertical "full-employment" line determines the natural rate of interest rn. That's the (real) rate of interest at which desired savings equals desired investment at "full employment output".

I have assumed for simplicity that expected inflation is zero, so I don't need to insert a vertical "expected inflation" wedge between the IS and LM curves. Nominal and real interest rates are equal, and the equilibrium {r0,Y0}is where IS and LM intersect.

I have drawn this equilibrium where Y<Yn and r>rn. The economy is in recession. The central bank should increase the money supply to shift the LM curve right, lowering r to rn, and get the economy back to full employment. Or, the government should use fiscal policy to shift the IS curve right, raising both r and rn, and making them equal at full employment.

Also off-camera is an AD curve. The AD curve slopes down, because a fall in the price level increases the real money supply and shifts the LM right.

Now look at the New Keynesian (or Neo-Wicksellian) version:

The only difference is that the central bank is now thought of as choosing the rate of interest, rather than the money supply, so the LM curve is horizontal. The supply of money is perfectly interest-elastic at the rate of interest chosen by the central bank.

I have drawn this equilibrium where the central bank has set the rate of interest above the natural rate, so the economy is in recession. The central bank should shift the LM curve down and reduce the rate of interest to equal the natural rate. Or fiscal policy should be used to shift the IS curve right to raise the natural rate of interest to equal the rate set by the central bank.

Off-camera, the AD curve is vertical. A fall in the price level will reduce the demand for money, but the central bank will accommodate by allowing the stock of money to fall proportionately, to keep the rate of interest constant.

This vertical AD curve means that the central bank must actively adjust the interest rate to keep the price level determinate. If it keeps the interest rate permanently above the natural rate, output demanded will be less than full employment, and the result will be accelerating deflation. If it keeps the interest rate permanently below the natural rate, output demanded will be above full employment, and the result will be accelerating inflation. On average, the central bank must set an interest rate equal to the natural rate (plus target inflation, to allow for the difference between real and nominal rates of interest).

Finally, look at the MMT version:

It's exactly the same as the New Keynesian version, except that the IS curve is vertical. The IS is assumed vertical because the rate of interest is assumed to have no effect on either desired savings or desired investment.

There is no natural rate of interest in the MMT version. It's undefined. If the IS curve lies either to the right or to the left of full-employment output, there exists no interest rate such that desired savings equals desired investment at full employment output. If, by sheer fluke (or by skillful fiscal policy) the IS curve is exactly at full employment, any rate of interest will make desired savings equal desired investment at full employment.

The MMT AD curve is vertical. A fall in the price level will not increase the real money supply and reduce the rate of interest (just like in the New Keynesian version, unless the central bank responds actively). But even if the rate of interest did fall, it would not increase output demanded. So, the AD curve is doubly vertical.

Monetary policy has no effect on AD. Fiscal policy can be used, and must be used, because this model, with its vertical AD curve, has no inherent tendency towards "full employment" output. The price level is indeterminate, unless active fiscal policy makes it determinate.

Since monetary policy has no role to play in determining AD, the central bank can set any interest rate it feels like setting. Indeed, it might as well set a nominal interest rate near zero, since this reduces the transactions costs of people converting between currency and bonds to try to avoid the opportunity costs of holding zero interest currency. (This is Milton Friedman's "Optimum Quantity of Money" argument in a new setting, except the central bank can set a 0% nominal rate even if positive inflation means that the real rate is negative).

The rate of interest plays no allocative role in savings and investment. It does not coordinate intertemporal consumption and production plans of households and firms. It merely re-distributes wealth between borrowers and lenders.

In a standard model, the government has a long run budget constraint. The present value of taxes must equal the present value of government spending (plus the existing national debt). The government can't borrow, and borrow to pay the interest, indefinitely, because the debt/GDP ratio would grow without limit. But this long run budget constraint only applies if the rate of interest on government bonds is above the long run growth rate of output. If the nominal/real rate of interest is less than the growth rate of nominal/real GDP, the government can run a stable Ponzi scheme. It can borrow, then borrow again to pay the interest, and the debt/GDP ratio will still fall over time, because the debt is growing at the rate of interest, which is lower than the growth rate of GDP.

If the central bank can set any interest rate it likes, it might as well set a rate of interest below the growth rate of GDP. So the government debt becomes a stable Ponzi scheme, and there is no long run government budget constraint in the normal sense. The only constraint on fiscal policy is that if the government runs too big a deficit and/or allows the debt to grow too large this would cause the IS to shift to the right of full employment output, and so causes accelerating inflation.

Actually, the ISLM framework is overkill in this context. The whole point of the ISLM framework was to reconcile two competing theories of the rate of interest: loanable funds ("the rate of interest adjusts to equalise desired savings and investment"); and liquidity preference ("the rate of interest adjusts to equalise the demand and supply of money"). IS shows the loanable funds answer, and LM shows the liquidity preference answer, and the ISLM model show that both answers depend on the level of income. So both are partly true. (Except in the long run where income is determined by full-employment, so only loanable funds determines the natural rate of interest). But if savings and investment are both perfectly interest-inelastic, we might as well revert to the simple Income-Expenditure Keynesian Cross model to show the underlying MMT macro model.

MMTers have a liquidity preference (LM) theory of the rate of interest, and a loanable funds (IS) theory of the level of income.

Comments

You can follow this conversation by subscribing to the comment feed for this post.

rsj
to suggest the market interest rates don't determine investment is not the same as saying
investment decisions are made without a time discount of some sort
at least mobilizing in the back of a deciders head

the system can be both determined and its decision makers faced with radical uncertainty
if the agents have their causal reasoning behnd every choice the system is determined
if the deciders lack complete info about everyone elses actions till kingdom come
even secondary uncertainty over lays the primary natural uncertainty
oh it spirals off here

but simple mechanicals jazzed up with a silly randomizer
isn't the only way
to get results that look like we see out there in the actual marketplaces of earth

---------------

nb

when uncertainty is as radical as it is when viewing the prospects for a new plant built here starting tomorrow
then to suggest a criterion for rational choice gets messy and problematical in the extreme

bware
the cone heads that suggest otherwise
are prolly performing a card trick on you

it delights me to see lerner tossed about here
might i urge his perspective

realytics
and why
because now we have the tools of a propr demiurg we can make happen ..more or less...what we want to make happen
its not realying on divine providence or best of all possible worlds spontaneous conjunctions
or the worship of jesus's miracle of the markets
as described in the lost gospel of saint mammon

in the case of norte amigo lands
the state can make ull employment and stable development partners
without pretending there is a single all rational agency like an over soul behind the micro foundations

as lerner shows us

we need a thermostat to control total output motions
and a cap and trade system to control price level motions

and as to micro
all we need to be liberal legit
is a healthy skill at mechanism design
and hawk eyes looking for pareto improving moves
to guide us thru the stiglitz-ian millions upon millions of small inefficiencies failures incompletenesses
etc that post samuelson-arrow post modern micro theory reveals to us

---1970 -1990 ---

hows that for give me a second
to me tell you my plan eh ??

recall the mothers of invention goof ranting :

" Do you think that I'm crazy?
Out of my mind?
Do you think that I creep in the night
And sleep in a phone booth?

Lemme take a minute &
tell you my plan
Lemme take a minute & tell who I am

“Let me put it another way. The orthodox New Keynesian view is that Y equilibrates S and I in the short run, given the r set by the Bank. But in the long run, when Y is set at "full employment" Y cannot adjust to equilibrate S and I, so the r set by the Bank must be adjusted to equilibrate S and I.”

So r follows rn.

But why is rn not a (partial) function of the path of r?

I.e. why does r not (partially) determine rn?

That would mean rn becomes obsolete as quickly as r (t) changes value to r (t+), and that r is always the dominant force.

“If MMTers did believe what my crude model says they believe, then the MMT policy prescriptions make sense. In that sense, my reverse engineering gets the right answers.”

"Isn't the QTM itself an example (perhaps the clearest example) of a theory that fails via the Lucas Critique?"

You're right. I had two other ideas in mind. The QTM can give you a ballpark estimate of the price level--it can explain why Japan's price level is roughly 100 times higher than the US price level. (Nick says Keynesianism can't do that--which I see as a huge flaw.) Second, quasi-monetarism (not the QTM) is the best way to model the monetary system. It has a nominal anchor.

Suppose the US adopts Japanese monetary policy. The QTM predicts the US price level will rise by several orders of magnitude. And the Keynesian theory predicts . . . I'm not quite sure what it predicts. What would happen to US interest rates right now if we adopted Japanese monetary policy? I have no idea.

Monetary policy has certain long run effects on nominal aggregates. The short run affect is largely determined by expectations of that long run effect. Thus the QTM explains the long run effect, and quasi-monetarism explains the short run effect.

Scotty seems never to consider the pricing system might determine the money supply in a discrretionary credit based market economy
The rough relationship is produced from the other direction
Output and prices induce the necessary money supply

I don't claim to actually know the MMT literature, but I think I understand intuitively its critique of the stuff that's taught in econ grad schools. And I would say that it is precisely the following assumption that is (one of) the problems that MMT seeks to address:

NR: luis: "thanks. this is what confuses me - the thing about how net financial assets are created/destroyed seems to me, when I translate it into terms I understand, as a perfectly unremarkable restatement of text book macro. But (some) MMTers portray it as an insight (we know how the monetary system really works!) so I must be missing something."

Because financial assets aren't real goods, every financial asset identically also represents a liability. The issue is that some financial assets (bank deposits, money market funds, repos) are also money. And these forms of money are "backed" in the private sector by the countervailing liabilities (loans, commercial paper, etc.) that may or may not have a "true" value commensurate with the value on the banks' books -- or with the amount of money created in exchange for them.

Thus (i) the financial asset "identity" is dependent on the quality of banks' loan origination procedures, and (ii) the money supply (and its stability) are also dependent on the quality of these procedures and the central bank does not control the money supply, so it's not so clear what it is that an LM curve represents.

Paine, I think we can all agree that a monetary reform making pennies the medium of account will increase prices by precisely 100-fold (the ketchup example.) The implicit assumption is that all nominal contracts will be revised 100-fold. The more interesting question is what happens when the base increases 100-fold, but nominal debt contracts are not re-adjusted.

I am not a card carrying MMTer but let me try my hand at explaining the bond versus cash issue.

1. Insofar as net financial wealth is concerned, bond and cash are similar and unique when compared with other financial assets. All other financial assets are directly or indirectly claims on other physical assets or cash flow from them. Government bonds and currency are not. As such. they are countercyclical--their value relative to other assets goes up during downturns and vice versa.

2. Under boom conditions, lots of financial assets behave as if they are money or close money substitutes, especially if they are short-duration and are nominally fixed claims. For example commercial paper. In downturns, they lose their "moneyness." In booms you don't need the government providing the net financial assets because the private sector is working overtime to produce net financial assets (as asset prices go up in relation to the credit that was created to finance and fuel them). However, this process is inherently destabilizing (Minsky).

3. During busts, only the government can provide net financial assets. Whether this comes in the form of bonds or money is distinctly secondary. Once the private sector demand for net financial assets if satified demand for goods and services will take care of itself.

4. Mainstream monetary policy is almost entirely focused on rearranging the composition of money+government bond held by the public. This makes sense in a gold standard world, where government government bonds are "inside" asset as well and gold (and money backed by it) is the only uncorrelated financial asset. So, an increase in the amount of gold (say a new find) would be expansionary. it has no relevance for the fiat world.

5. In the fiat world, although money is technically an "inside asset" in the sense that its value is ultimately underpinned by the society's productive capacity and the government's power to tax a significant portion of it, in practice it behaves like an outside asset. In places where this does not hold true--you have Zimbabwe (or name our country). And in the fiat world, government bonds are not really different from money.

6. The exchange property of money (vis-a-vis) bonds is vastly exaggerated. Insofar as pure exchange for mere economic activity (as opposed to financial market and credit activity) as long as you have some concept of money, a system of book-keeping and trade credit is generally sufficient.

7. To Scott Sumer: when money supply is endogenous, the idea that money stock determines the price level is meaningless. It is tautologically true (if you can define the correct money stock to use) but vacuous in terms of understanding the causal forces.

8. The IS curve cannot be seen in isolation of the LM curve--they are not independent. Common variables drive them. A rise in perception of uncertainty will drive demand for money from a portfolio allocation perspective and simultaneously drive down the demand for physical investment (IS).

9. It is not that interest rates have no influence. Rather the influence of interest rates is rather nonlinear, context-dependent, and generally quite uncertain. Other than housing, most investment is not sensitive to cost of capital, at least at the margin. Yes, financial asset prices are sensitive to interest rates but that relationship is obviously not invariant and quite volatile. Besides, if asset price appreciation is your objective why not use fiscal policy to increase net financial assets? At least that is more transparent and perhaps less plutocratic.

JKH: "Parenteau’s essay is about the MMT sector financial balances model – to which Krugman’s graph is equivalent (according to Parenteau).
Can you explain simply the connection/equivalence between the Keynesian cross and the MMT sector financial balances model?"

where Y is income, T is taxes, so Y-T is disposable income. a is some positive number, and b (the marginal propensity to consume) is between 0 and 1. So the consumption function just says that consumption demand depends positively on disposable income.

Here's a simple theory of taxes:

T=tY

(taxes are proportional to income).

Assume I and G are exogenous (fixed).

Substitue the behavioural functions into the accounting identity and you get:

AE=C+I+G=a+b(Y-T)+I+G=a+b(1-t)Y+I+G

That's the AE curve. It has a positive intercept, and an upward slope of less than one. AE (demand for output) increases when income increases.

Now we add the equilibrium condition:

Y=AE

That's the "45 degree line". Income is determined by demand for output, and the two are equal in equilibrium.

Where the AE curve crosses the 45 degree line we get the equilibrium level of Y:

Y=a+b(1-t)Y+I+G

Solving we get the equilibrium for Y as:

Y=[a+I+G]/[1-b(1-t)]

OK. That's the ECON101 macro model, for the last 50(?) years.

Now, let's take the exact same equilibrium condition:

Y=C+I+G

and play with it. Subtract C from both sides:

Y-C=I+G

Subtract T from both sides:

Y-T-C=I+G-T

Define savings S as:

S=Y-T-C

So we get:

S=I+G-T

Rearrange, we get the MMT equilibrium condition:

S-I=G-T

Substituting in from the behavioural equations for consumption and taxes we can re-write this as:

-a+(1-b)(1-t)Y-I=G-tY [edited to fix stupid arithmetic mistake]

Which (IIRC) are the two curves of the Krugman diagram, with equilibrium Y determined as the intersection of those two curves.

[Funnily enough, back when I was an undergrad we used to use this as our equilibrium condition:

I+G=S+T

We called it the "Injections equals Withdrawals approach". But we knew it was the exact same model as the Keynesian Cross, just a different way of looking at the same thing.]

Bottom line: what many people think of as the MMT model is mathematically identical to the model I have either taught or been taught for the last 40 years.

OK guys, confess: who was the blogger that came up with the name "MMT"?

It was maybe a brilliant marketing ploy to attract non-economists. But it has caused no end of confusion for us economists. Especially for those of us who have actually read Keynes' General Theory and Abba Lerner's Functional Finance.

Forget wading through the thickets of words and accounting. This is what really matters: this is what I should really have written about:

"Under what conditions would Abba Lerner be right about the long run government budget constraint and Functional Finance?"

That would have been a useful post that could have moved things forward. Instead, I'm trying to hack my way through thickets.

Keynes coined the term "modern money," and Wray named his book after that. But we always have used the term neo-Chartalist to refer to ourselves in academic circles. Bill Mitchell started using "modern monetary theory" on his blog a few years ago, and it eventually stuck. I don't know that the latter has actually been used by any of us to describe ourselves in an academic paper yet, though, and I don't know if we will.

Regarding Lerner, FF, and the IGBC, they are perfectly consistent with each other if by FF one means a fiscal policy strategy that improves the primary budget balance as the economy nears full employment and continues to do so 1-for-1 with increases in private spending when the economy is at full employment.

Aha! So I will blame Bill! I admit it was a brilliant marketing ploy. But I still am slightly pissed at him for using it! "Functional Finance" is much more descriptively useful. "Chartalist" reminds me of Knapp's State Theory of Money -- one of the worst books I have ever (tried to) read. Abba Lerner is streaks ahead of Knapp. Because you can understand what Lerner is saying, and if he's right he's saying something important and substantive.

"Regarding Lerner, FF, and the IGBC, they are perfectly consistent with each other if by FF one means a fiscal policy strategy that improves the primary budget balance as the economy nears full employment and continues to do so 1-for-1 with increases in private spending when the economy is at full employment."

That would require a very large fiscal multiplier, wouldn't it? That would make the standard Keynesian Cross equilibrium unstable? MPC greater than one? Or, instead, some sort of "pump priming"/"Kick starting" multiplier where a *temporary* increase in G gets the ball rolling and causes a *permanent* (or at least long-lived) increase in Y?

My mind was going in a different direction. It all depends on whether r can be kept below g, for the stable-Ponzi regime to hold. And that depends on the shape of the IS curve and the mix of money vs bond financing (not very MMT). Loose money and tight fiscal (relatively speaking) would do it. My vertical IS assumption would be sufficient but not necessary.

But I haven't worked it out. Just came up with the idea a couple of hours back.

Start with these from your discussion:
-a+(1-b)(1-t)Y=G-tY
Y-T-C=I+G-T

End here for sector balances with "behavior":
Y(1-b)(1-t)-a-I = G-tY

The left hand side is desired net saving given Y as defined by MMT'ers. The right-hand side is the govt's budget stance, again, given Y.

To your point about accounting vs. economics . . .

First, one needs economics to create behavioral relationships, as you did, and would need the latter to solve for Y and get actual net private saving and the govt's balance.

Second, one needs accounting to ensure stock-flow consistency in building the model (though this model has only flows) consistent with how "score" is kept in the real world. It also aids in interpreting the results--as when one solves for Y with one of your very early equations (the basic multiplier equation from Econ101). With the sector balances equation, we understand that (1) any fiscal policy action "works" by adjusting private incomes via government spending or taxation (raising G or lowering T lowers Y), that is, govt deficits raise net private saving; (2) any monetary policy action "works" by adjusting desired spending given Y (changing I or a), that is, monetary policy is stimulative when it induces the pvt sector to reduce its net private saving. These insights are generally absent from the traditional interpretation of these models, as the effects of stimulate policy are seen as equivalent (in as much as they are seen to actually "work," which is a separate matter altogether).

Blending the economics with the accounting, MMT'ers along with folks like Richard Koo understand that the non-govt sector isn't likely to re-leverage on the scale necessary to return to full employment anytime soon. It also makes clear that austerity policies can only avoid worsening the recession if the non-govt sector is ready to releverage, and that if the non-govt sector instead tries to continue deleveraging in the face of austerity policies both the economy and the deficits will worsen. One could get some of the latter these points from a typical IS-LM if one wanted to actually do the math, but it's rare that someone specifies the balance sheet positions required for either outcome to be true using only IS-LM.

I'll stop there as I'm being summoned by my better half. Hope that helps out a bit.

"The more interesting question is what happens when the base increases 100-fold, but nominal debt contracts are not re-adjusted."

But the CB cannot increase the base by 100 times because it doesn't have that many government bonds to purchase. There must be deficit spending first, and only then the CB can increase the base by purchasing some of those bonds.

I think you are envisioning the CB conducting fiscal policy. I also like to conceptually view monetary policy as something that is expenditure/revenue-neutral for the government, whereas fiscal policy is an adjustment in expenditures and revenues (apart from interest rate effects).

But this ceiling on monetary policy has an interesting side effect (to me). Namely, because the total stock of money -- MZM -- held by the public is roughly equal to the federal debt held by the public, when the CB purchases a bond for a deposit, then on the margin, the household can sell the deposit back to the banking system in exchange for another bond (or paper, etc.)

Households do not need to spend unwanted deposits by purchasing goods. They can spend unwanted deposits by purchasing financial sector debt, and this pushes the excess base back onto the banks, where it sits as reserves, even as household deposit levels are unchanged. The only thing that changes is the relative price of bonds and deposits. So if the "money" in the money demand function, is deposits and not the base, then the CB has not succeeded in increasing household money holdings.

This would a "monetary pessimism" scenario, in which velocity changes negate the effects of an increase in the base. It's a lower bound on the effectiveness of monetary policy on the price level, and this is a function of the size of MZM.

An increase in the base does not force MZM -- "money" -- to increase as long as the size of the base is less than the size of MZM. And historically the growth of MZM has not tracked growth of the base, but has tracked the size of federal debt -- MZM moves with fiscal policy, not monetary policy.

But as the CB keeps buying bonds then under our pessimism scenario, once MZM = Base, then an additional increase in the Base must lead to an increase in MZM. At that point, households will have no option but to purchase goods if they want to reduce their deposit holdings. The question is, why would they? As their net-worth has not improved, why would they increase spending? But assume that they do. Then there would be a price effect. But unfortunately, the price effect kicks in only after the critical value, and the critical value is the ceiling on how much the CB can expand the base. Therefore under this pessimism scenario, the CB cannot force prices to rise by increasing the base. Rather, it must accommodate rising prices by expanding the base.

I don't understand what you are trying to say. I don't think time discounts are particularly important at the macro level. And let's abstract away from risk, if you like. Still, firms know their cost of capital. They are acutely aware of how many dividends they need to pay, and the rate of increase of those dividends. It has little to do with psychology.

Similarly, shareholders are not going to price the firms based on psychology, but based on arbitrage. They can purchase land, they can purchase bonds, or they can purchase equities, or even foreign bonds or equities.

Psychology is relevant in assigning a weight to risk and trying to determine which asset will outperform the other, but over the long run it is nominal arbitrage and not psychology that rules the roost.

If you pin down bonds to have a very low rate of interest, then you are going to pin down the other assets to have a low rate of interest, too. And then firms will know that their cost of capital has been lowered. They will increase investment and their profitability will (eventually) decline to equal their lower cost of capital.

The whole _point_ is to try to increase investment by lowering the rate. At least over the long run, I don't see how you can argue that investment will not increase as a result of an decline in the short rate. There are many, many examples of over investment and declining productivity as a result of governments setting rates too low. Low borrowing rates are basically a tax on consumption and a subsidy to investment.

This is the preferred development model, after all, so we can take a look and see what the effects of this model are. You have China and Japan as the shining examples, but also the Latin American nations in the 60s, etc.

The effects are a big expansionary boom followed by a financial crisis and lost decade, and it is hard to then raise borrowing rates as it leads to large liquidation of investments that are only profitable at the low rates, but not the higher rates. Lowering a firm's cost of capital, encouraging more fixed investment, is asymmetric to raising the cost of capital, requiring liquidation of the fixed investment. An economy can easily increase leverage, but it cannot easily de-lever. You end up stuck in a bad equilibrium.

JKH: "Nick, As you're familiar with Lerner, how would you interpret the meaning of "functional" as in "functional finance"? (I'm not so familiar)"

I read it 25+ years ago, when trying to get my head around Barro on Ricardian Equivalence vs Buchanan of the future burden of the debt. It was an interesting 3-way fight. Lerner wanted to have it both ways. Unlike Barro, and like Buchanan, Lerner said that bonds are net wealth, and so a helicopter drop of bonds increased demand. Like Barro, and unlike Buchanan, Lerner said there was no future burden. Barro is internally consistent. Buchanana is internally consistent. The only way I can think to make Lerner internally consistent is to assume a world in which a stable Ponzi scheme is possible.

What does "functional" mean (when Lerner says it)?

As best I can remember, it carries two meanings at the same time:

1. Choose whatever level of government borrowing has the best consequences; don't get hung up on rules of what is legitimate. Like a consequentialist system of ethics, rather than one based on moral duties. "Do what works". "I don't care what colour the cat is, as long as it catches mice".

2. Forget the long-run government budget constraint. Households have one; governments don't. The only limit on deficit spending is when Aggregate Demand gets too big and you cause inflation.

The second is problematic. Sure, governments can print money and households can't. But why, precisely, does that matter? (And, actually, MMTers need to better distinguish money from bonds if they want to answer that question properly; and saying that governments have taxing power doesn't answer that question, because the standard long run government budget constraint already incorporates taxes.)

Edit: I can answer it, BTW. It's because money, as medium of exchange, is held despite paying a rate of interest below the growth rate. So money is always a stable Ponzi (till we hit Zimbabwe or the ZLB). But bonds may not be a stable Ponzi.

1. It is always good to look at the same model from as many different perspectives as possible. Flows of goods, flows of money, and flows of financial assets. We understand it better, We can spot our hidden assumptions better. We can see whether our behavioural assumptions really make sense from all sides, or whether they have some hidden implications we would not agree to if we saw them. OK.

[Quasi-monetarist rant warning: and one of the things that pisses me off about keynesians in general is how so few of them understand that their models only make sense in a monetary exchange economy. Because they have never asked what would happen if goods could exchange directly for goods, labour, and bonds, without needing money.]

2. If there were only one financial asset though, and if it weren't the medium of exchange, how interesting would this be? If people are net buyers of goods they are net sellers of bonds. Big deal. One is just the negative of the other. With two financial assets it gets interesting. Because the mix of assets may matter.

{Quasi-monetarist warning again: and if one of those assets is the medium of exchange, that means the whole structure of markets is different, because anyone using monetary exchange is both a buyer and a seller of money, so you can't just look at the net flow of money, even at an individual level.)

Scott: In Barro's world, bonds are not net wealth (in aggregate). You would be richer if the helicopter drops bonds on you alone. But if the helicopter drops bonds on everyone, the present value of future tax liabilities cancels the increased wealth.

Buchanan says you are wealthier, and increase demand, because its the next generation that pays the taxes. So bonds are net wealth for the current generation, but a burden on the future.

Lerner wants to have it both ways. The current generation is wealthier, but there's no future burden.

The orthodox position (at least among those who have thought it through like Buiter) is that money is net wealth but bonds aren't.

BArro's internally consistent only if you assume monetary operations are different from how they really work. That's the problem with Ricardian Equivalence. Bill Mitchell destroyed it in a blog a few weeks ago.

"The orthodox position (at least among those who have thought it through like Buiter) is that money is net wealth but bonds aren't."

I don't *think* the argument is about whether something is net wealth or not, but whether deficit spending (i.e. the flow) can prevent a reduction in real wealth that would have otherwise occurred if there was no deficit spending.

I.e. assume that there is a demand for a _flow_ of money, say due to a obligations to meet dividend or bond payments.

You can say that if a single firm can't meet this demand, then it should be liquidated because it is not earning the real return demanded. However, if _all_ firms can't meet this demand, then you have a purely nominal income problem.

Now if the government were to just supply all firms with income -- then it can give money to the firms, which is passed onto households and then simultaneously sell bonds to households.

It is flushing a clogged pipe.

But this flushing will allow firms to meet their obligations and avoid liquidation, which would be a reduction in real wealth. Then the households can put the bonds into the safe, in expectation of the future tax obligation, while still maintaining their current level of real wealth.

The growth rate of the stock of debt triggers nominal income flows, and if these income flows can prevent liquidation of real assets, then they can prevent a decrease in real wealth even if the level of government debt is not itself net wealth.

But if the level of the stock of debt is irrelevant as the tax liability cancels the bonds, then you don't care about the level of debt -- you might as well pick the right growth rate of the debt level to generate the right nominal income flows. This is how I think of functional finance. It's hydraulic Keynesianism that has nothing to do with Ricardian Equivalence.

And the risk that I glossed over is that if _all_ firms can't meet their obligations, then you may not just have a nominal income problem, but an excessively high return-demand problem, in which case Keynesian demand management can then sustain these excessively high profit rates. So there are real risks to these policies that would call for, in the long run, maintaining a stable debt to output ratio. But that is a whole separate issue from the short run issue, and the desire to maintain stable ratios is not due to solvency constraints per se, but again due to a desire to effectively manage the real economy.

Scott: "BArro's internally consistent only if you assume monetary operations are different from how they really work. That's the problem with Ricardian Equivalence. Bill Mitchell destroyed it in a blog a few weeks ago."

Let me explain how I react to a comment like that.

I read the "..how they really work." and I think: "Oh dear. Do I have to go over to Bill's blog and wade through thickets of mind-numbing institutional detail to try to figure out what he's really saying, then find a way to explain simply whether he's right or wrong?"

And, with no disrespect for Bill, the argument from his authority doesn't really cut it.

I have read Barro. I understand Barro. I have made up my own views on the extent to which he is right or wrong. Hunderds of other really good economists have done so too, and I have the benefit of their views.

The confusing part for me is the use of the word "wealth" or "net wealth." Those are accounting terms, and dropping bonds absolutely adds to net wealth in the aggregate, ceteris paribus, by accounting definition. The non-govt sector now owns liabilities of the govt that earn interest.

Barro, though, says that at the same time the PV of all future liabilities has increased by the same amount, so no net wealth.

Both are correct according to their own respective logical constructs.

And with a "money" drop, in accounting terms, net wealth hasn't changed by any more than with the bond drop, but from Barro's perspective (and Buiter's), the "money" drop does not create future liabilities for the non-govt sector and so is net wealth.

Again, both are correct according to their own frameworks.

More later in terms of reconciliation, but have to go to bed now. Thanks for patience and for not ripping me (too much of) a new one above (at least no more than I deserved).

"With two financial assets it gets interesting. Because the mix of assets may matter."

You are still misrepresenting the MMT position here. The argument is NOT that the mix doesn't matter. The argument is that whether or not the govt sells bonds, this doesn't stop the non-govt sector from adjusting the mix.

If the CB sets the target rate above the rate paid on reserve balances, then either the CB or the Tsy must offer a interest-bearing liability (that in either case is ultimately the Tsy's liability) to keep the target rate set. But, if the non-govt sector prefers a different mix, it can demand more base and the mix of Tsy's to reserve balances will be altered. And if we consider, as just one example, that the non-govt sector can leverage Tsy's with deposits, there's all sorts of other mixes it can create beyond just base vs. Tsy's.

If the CB instead sets the overnight rate equal to IOR, it can select the mix on its own between reserve balances and Tsy's. But in that case, from the perspective of banks, reserve balances and bills are perfect substitutes, and so they are indifferent to the CB's chosen mix at least between those two. And, as above, outside of those two assets, all sorts of other mixes can be created. There's never any operational limit to how many deposits can be created, for example, and so the qty of deposits that can set the mix with reserve balances/Tsy's (substitutes in this case) is again up to the non-govt sector.

OK, so I didn't go to bed yet, but going now and will get to Lerner/Barro, etc. tomorrow hopefully.

"And with a "money" drop, in accounting terms, net wealth hasn't changed by any more than with the bond drop, but from Barro's perspective (and Buiter's), the "money" drop does not create future liabilities for the non-govt sector and so is net wealth."

Govt bonds aren't net wealth, so a money drop can't be net wealth either--unless the PV of income increases, i.e. the bonds or money drop are productive.

It makes no sense to imagine, as a general principle, the household sector making itself wealthier by lending itself money, whether through the veil of firms or through the veil of government.

"t makes no sense to imagine, as a general principle, the household sector making itself wealthier by lending itself money, whether through the veil of firms or through the veil of government."

Except that, in an industrial economy, that is how wealth is created.

I once worked for a firm that had a lead time of 3 years. 3 years of product development and testing before the product shipped and could be sold. They were paying an engineering team that had salaries of about 500 million per year, so 1.3 Billion of wages spent before a dollar was earned in revenues.

The private sector always makes itself more productive by lending itself money, and this is the _only_ way that the private sector can make itself wealthier and more productive.

Unfortunately, sometimes the private sector does not make itself wealthier by lending itself money. Nevertheless, lending money is the only way to gain real wealth, and a reduction in lending always results in a reduction of real wealth.

I think the point about ISLM from an MMT perspective is that it's not a dynamic stock-flow consistent model. You can of course jack-boot the MMT model from a policy perspective into ISLM. And why not? It's just a model.

But it might help to think about how an SFC model differs from ISLM. It's a pity that you can't use subscripts in the comments boxes, or I'd give the whole model (it's only 11 equations long—I'm looking at the "SIM" model from Godley & Lavoie, 2007).

Consider first the standard Keynesian multiplier analysis. An increase in G does not simply cause a 1-to-1 increase in Y. The equilibrium increase is given by ∆Y = ∆G / (1 – MPC), because the increase in G increases Y, which increases C, which increases Y again.

In Godley and Lavoie’s model, flows add to stocks, and stocks affect flows. A constant increase in G, for example, funded by deficit spending, for a constant increase in Y, implies a national debt going to infinity in the limit, which is impossible. Instead they model the long-run equilibrium of the economy as a stationary steady state in which the levels of all the variables (stocks and flows) are constant. (In a model with growth, the ratios of the variables are constant). In the steady state, the private sector cannot be accumulating public debt, and govt expenditure must equal taxes (and the propensity to consume equal to unity). Therefore, a permanent increase in G continues to act through the model raising Y until it reaches the steady state where there is no change in the stock of financial assets and Y settles on its new long run equilibrium value, equal to the ratio of government expenditure to the tax rate (what Godley and Lavoie call the “fiscal stance”).

"Except that, in an industrial economy, that is how wealth is created."

I’m talking about sector financial balances. A naive SFB approach goes like this: if the govt runs a surplus, the private sector is running a deficit (assuming a closed economy), and therefore the private sector is somehow “worse off”, because its income is lower or it is dissaving or whatever. And by extension, obviously, vice versa. But households don’t become wealthier when another sector lends them money (and they don’t become poorer when the reverse is true) because they already own all wealth. They lending to and borrowing from themselves.

vimothy, you are merging nominal and real here. The distinction lies in whether bonds are perceived as an addition to one's financial wealth or, as in the Ricardian story, they are perceived solely as future tax liabilities. The multiplier effect that transforms financial into real wealth is a separate issue. In that sense, deficit spending is at first just that - the household sector lending itself money to make itself feel more wealthy although it has no real wealth to back that feeling - yet. It is in a further step that this perception of wealth is then believed to induce consumption followed by investment, but they are separable and also very much dependent on the distribution of said wealth.

Since private credit is demand led, the same can not be said for bank lending, at least during recessions. During booms, demand for credit boosts investment and asset prices, which leads to the perception of rising wealth, which in turn increases demand for loans etc. But this is pro-cyclical and thus not stable. And, during recessions, this mechanism does not work at all. There is no (or never enough, let alone quick enough) bootstrapping with demand led monetary aggregates according to MMT.

Of course you are right that it makes no sense to imagine both effects as functionally separable. One must follow the other! In fact, such separability would render MMT and all of Keynesianism with it, null and void instantly. But it does make sense to think them through separately.

Just to observe - those alternatives all become accounting permutations at the end of the day.

Scott is right – net wealth is an accounting measure.

Similarly, whether or not there is a “future burden” and whether to give that concept representational substance becomes an accounting system choice.

Exit Nick stage left, screaming?

But before that exit, I’d just say we need a happier marriage between economics and accounting. As I said once before, accounting is not the enemy.

Interesting to me that the CFA program (Chartered Financial Analyst) has a modular structure (or at least it did when I took it) that includes such sections as economics, accounting, equity analysis, debt analysis, quantitative analysis, and ethics. The point being that it is a course of study in which economics and accounting are aligned in parallel to achieve some analytical goal. They are considered distinct but complementary, each essential to the goal. I was quite interested to discover that Steve Waldman is a CFA. It shows a bit in his writing about economics.

MMT comes at economics through monetary operations and accounting. It’s a gateway.

My impression is that you come at accounting with a view that economics supersedes accounting. Perhaps I’ve got that wrong.

But economics is inextricably tied to logical accounting representation of some sort.

Accounting, while not sufficient, is necessary.

Although I don’t think “to the penny” is a particularly good mantra in most cases - accounting systems are also choices, and the most important aspect is consistency, whatever the choice.

In all seriousness, the economics profession has been in a state of intensive self-reflection in connection with its overall role pertaining to the financial crisis. I think the point on the relationship between economics and accounting, and between economics and monetary operations should be part of that reflection. These are more pointed versions of what has been recognized more broadly as shortcomings in dealing with the nature of financial system risk as part of economics.

It is ironic to me that the economics profession has been as public as it has been in its self-flagellation, because some perceive its problem to be one of excessive self-reference in its intellectual framework.

Have you blogged on the “profession crisis” issue yet? I know you’ve fired off a few cannons on some specific issues such as accounting and MMT, but I don’t recall regarding the broader topic.

These observations are not intended to upset you or dismiss what you contribute, particularly through your blog, in such a public way. They are just observations about economics as a not yet perfected system of thought.

Scott: no worries. Paying taxes is one thing. But filling out the damned forms is cruel and unusual punishment. I was once filling out both Federal and Quebec tax returns at midnight, using my daughter's Mickey Mouse calculator. (Every time I made a mistake, and pressed C, it would play the MM theme tune.) Accountants are well worth the money. Not so much for the taxes they might save you, but because they are cheaper than shrinks.

vimothy: I have some familiarity with the basic idea behind the Godley/Lavoie approach. I see it as an extension of the approach pioneered by Christ and Blinder/Solow and Tobin/Buiter (IIRC) back in the early 1970's. (Arch-monetarist David Laidler taught it us in MA macro in 77). If the government runs a deficit, the stocks of money and/or bonds are changing over time. And what happens over time (and whether a steady state exists) depends on different people's marginal propensities to consume out of income and wealth, plus other stuff. Mark is also a semi-colleague (Carleton has a joint PhD with U of Ottawa) so Mark calls me in to act as internal/external supervisor/examiner for his students, most of whom are working on SFC models.

Here are my problems with it:

1. These are *very* long run models, and yet there's generally not much at all in the way of a supply-side. Holding P and/or W fixed in that very long run is problematic.

2. The models have a well-defined time-path for future income, and yet this does not seem to affect people's expectations and current behaviour. Current consumption and investment should depend on expectations of future income and other things.

3. (Something I haven't yet thought through, but am uneasy about.) There's something problematic about having two independent parameters: an MPC out of income; and an MPC out of wealth. A bond is just a flow of income (coupon payments) represented by a bit of paper. Why should the fact that a flow of income is represented by a bit of paper (securitised) make any difference to how much a person consumes? That's not a rhetorical question, because I recognise that the bit of paper means that the flow of income can be sold to another agent, and that option value of a securitised flow of income may matter in some contexts, like when there's uncertainty. But that is not modelled in any SFC models I have seen. Milton Friedman's Permanent Income Hypothesis reconciled the MPC out of income and the MPC out of wealth in a consistent way. Agree or disagree with the PIH, but Friedman tackled that question. SFC models (AFAIK) do not. And if they did try to tackle it, it opens up a whole can of worms, like future tax liabilities as unsecuritised negative wealth.

Scott: Yep. If money pays interest, equal to the bond rate, then money and bonds are equivalent in terms of net wealth, as far as I can see. Currency is net wealth, by that way of thinking. Essentially, the net wealth is the capitalised value of the government's rents (seigniorage) from its monopoly on note-issue.

[Quasi-monetarist mode on: but this whole analysis misses the medium of exchange property of money. And because money is a medium of exchange, people will accept money in exchange for goods even when they do not wish to *hold* extra money. There is never an unwillingness to accept the hot potato of money, only a willingness to pass it one if there's an excess supply of money (provided each believes he can pass it on). This means that you *can* create an excess supply of the medium of exchange in a way you can't create an excess supply of bonds. The stock of money can never be simply demand-determined in the same way that other assets can be demand determined. Q=min{Qd,Qs} does not work for money in the same way it works for other goods. It is always, in some sense, as if new money is helicoptered into existence. That is not true with bonds. And my argument here is not just with MMT but with the whole "under current monetary policy, the stock of money is demand-determined" Neo-Wicksellian/New Keynesian orthodoxy. If you were preaching this part of MMT to almost anyone else, you would be preaching to the choir.]

At one level, Barro's Ricardian Equivalence proposition is pure accounting. And it was an eye-opener for many of us who hadn't thought through that accounting.

But at another level it isn't. Behavioural implications of bond-financed tax cuts depend on: whether real people understand that accounting; who gets the assets and who gets the liabilities; distorting effects of non-lump-sum taxes (actions to try to avoid those liabilities by individuals); borrowing constraints; whether the accounts add up in a Ponzi world, etc.).

"Have you blogged on the “profession crisis” issue yet? I know you’ve fired off a few cannons on some specific issues such as accounting and MMT, but I don’t recall regarding the broader topic."

I haven't. Can't really think of anything very exciting or insightful to say on the subject. I could just repeat the usual stuff: the need to integrate finance into macro better; need to think outside the currently-fashionable boxes more; less technique more thinking. We just need to keep plugging away as best we can. Economics is hard. And we need thousands of eyes to keep an eye on everything that might blow up. If there were a magic key to open the door of all understanding, we would probably have found it by now.

And much of the "self-flagellation" isn't really. It's some economists flagellating other economists. Which they have always done (at least in macro). This is nothing on the old Keynesian/Monetarist rows.

That’s ironic because I’m trying to be careful to distinguish between the two. I was responding to Scott and Nick’s discussion. Although govt bonds may add to “net wealth” by “accounting definition”, in a non-tautological sense, govt bonds are not wealth, because for a given path of G, Y1 + Y2/(1+r) is unchanged. We know what the optimal solution for the private sector here is; whether it acts like this in practice is, as you suggest, another matter.

What’s more, I don’t believe that rising nominal income is the be all and end all of macro and I don’t believe that guaranteeing a constant rise in nominal income is the same as guaranteeing a constant rise in real GDP. If the demand for money or safe assets rises in a recession then the govt should satisfy this demand to avoid a further painful contraction. But I don’t think this should be mistaken for growth policy, and the initial liquidation and reallocation of “malinvestments” should still be allowed to take place.

Macro aside, there is still a massive gulf between economists and accountants. I can explain in 10 minutes to any bright first year student why assets and liabilities need to be adjusted for inflation to get a true picture of wealth. But when I try to argue this with accountants, for e.g. the University balance sheet, I get precisely nowhere. If I didn't know they were really bright people, I would think they were thickies. They must have their reasons, and sometimes I vaguely glimpse some sort of rationale for what they must see as protecting the integrity of accounts from scam-artists like me. But I don't really understand it.

"I don’t believe that guaranteeing a constant rise in nominal income is the same as guaranteeing a constant rise in real GDP. "

Sure, but writing down f(K,L) does not mean you are saying anything "real", either. At least for rising nominal income, we have some accounting data. We don't have any data to believe that anything like f(K,L) is relevant for macro at all.

I think there are distinctions between accounting as a profession, accountants as professionals, and accounting as a generic system of arithmetic logic (including choices involved in system “fine tuning”).

There are contentious issues within the profession about accounting choices, professionals within the profession who range from truly brilliant to dullard (like all professions), and outsiders who appreciate its broad utility in business and economics - in some form - whatever the choices are about how to construct an internally consistent system of accounts.

BTW, I was always intrigued about how the old Brascan was created by this guy, who was obviously more than a pencil pusher:

Re Godley & Lavoie, I mostly agree. The treatment of production and prices is basically non-existent, their definition of wealth is all wrong, there are no microfoundations, “expectations” are just lagged variables, it’s deterministic, etc, etc. I mean, it’s a bunch of assumptions about how aggregate variables behave in a deterministic system heading towards a steady state, isn’t it. (No business cycles)! I don’t see that as radically superior to the neoclassical approach. Can be fun to play about with in EViews though. Incidentally, I remember reading in some paper that stock flow consistency is a precondition of DSGE models, so it’s not like the principle is unique to PKE.

I can explain in 10 minutes to any bright first year student why assets and liabilities need to be adjusted for inflation to get a true picture of wealth.

Maybe I'm not so bright, but I'd say the picture is no truer than if you don't adjust for inflation, it's just much easier to follow. A function with one variable suits our (or at least my) limited ability to abstract much better than one with two, god forbid independent, variables. But mapping financial to real is a philosophical, not a mathematical challenge - one that needs to take place in any case, whether there is inflation or not. In the demand led, Keynesian world, this philosophical challenge is left to the individuals who each perform this translation in the privacy of their own preferences, which is of course very convenient for the economists (maybe too convenient?). But aggregating philosophy by mathematizing it, as I see much of economics, doesn't seem to have helped us much either. I think the prior simpletons at least free more of their mental capacity to appreciate the forest in its beauty without getting too bogged down about the trees.

Where I find MMTers run in to difficulties in their communication with other schools, is that all their talk about accounting is done with one final aim, namely to stop us thinking about accounting and get us to focus on the real side of things, such as employment etc. It's a bit like telling people not to think about unicorns because, hey, we've studied unicorns in great detail and we can assure you they don't exist. So, whatever you do, don't think about them! And of course we run out and come up with mathematical proofs that show that we can believe them into existence and that therefore they must exist etc.. Anselm of Cantebury comes to mind. http://en.wikipedia.org/wiki/Anselm_of_Canterbury#Proofs

Nick, the point is, nominal income is measurable and well-defined, whereas F(K,L) is not well-defined. You can of course measure the flow -- Y -- but you cannot observe F. And what bothers me most is that production is a process, and yet there is no "t" in there anywhere.

You are basically replacing the firm -- which has intermediate inputs, cost curves, etc -- with a growth theory heuristic that doesn't have any micro-foundations. Maybe there _are_ micro-roots there, but I can't see them.

Which is not to dismiss either approach, but I'm criticizing the criticism.

Nick, Regarding your quasi-monetarist comment: I agree that there is the possibility of disequilibrium in money markets but not in bond markets. I explain that with sticky prices; goods prices are sticky, and hence the currency market takes some time to adjust, whereas bond prices are flexible and hence the bond market adjusts instantly to a changed supply of bonds. Is that how you see things? (No obligation to respond if you are burned out with this post.)

Srini, You said:

"7. To Scott Sumer: when money supply is endogenous, the idea that money stock determines the price level is meaningless. It is tautologically true (if you can define the correct money stock to use) but vacuous in terms of understanding the causal forces."

I don't understand your comment about it being tautological that the money stock determines the price level. And when things are tautological, it is generally not necessary to find "the correct money stock to use"--it should be obvious.

It's true that under most policy regimes the money stock is endogenous. But that's a separate question from determining the causal effect of a change in the money supply. A Keynesian might argue that interest rates have a causal effect on output. Someone could point out that many countries peg their exchange rate, in which case the interest rate becomes endogenous. That observation is true, but has no bearing on the Keynesian claim that interest rates have a causal effect on AD.

I think money is important for similar reasons that Nick does. Cash is net wealth and government bonds are not (as a first approximation.) Having a stock of currency that is useful for transactions produces net wealth to a community. Increasing that stock 100 fold doesn't change the value of the real transaction services offered by that stock of currency, hence the real value of the stock of currency is unchanged, and hence prices rise 100 fold.

"The stock of money can never be simply demand-determined in the same way that other assets can be demand determined."

Since "money" is always someone's liability (unless it is a commodity money), whose liability is it that is not "demand determined"? This must be aside from portfolio shifts or asset swaps, since that presupposes some other liability that had to have been supply or demand determined (and MMT already fully recognizes that asset swaps don't have to be "demand determined" as in QE).

1. MMT models can be Ricardian as long as we allow for multiple equilibria--with deficits making it possible to reach higher equilibria, with higher real and nominal output that justify the government's original debt. The problem with Ricardian equivalence as formulated conventionally is that money is neutral in the long-run and there no role for the government to affect output, in the short and the long-run. Post-keynesians reject this. Government has the ability to affect output and internalize the fruits of its action through taxation.

2. Ricardian equivalence combined with backward induction (implicit in DSGE) and enforcing of no-default is problematic. Every path must ultimately lead to default (or worthless paper) in the sense that no government is going to last to perpetuity. Working backward, at no point can government debt have value. At the heart of it there is irrationality as conventionally understood or a belief in the "greater fool theory." Backward induction in games often gives counterintuitive results that generally do not accord with how people behave in reality. The same problem exists with Ricardian equivalence.

3. Scott: perhaps I am missing something. I checked out the price level (GDP deflator) and compared it with the monetary base, M1 and M2--they are not even in the same ballpark over, the past 10, 20, and thirty years. Now, assuming they were, if prices were determined by markup pricing (say) and the Fed accommodated the credit system's demand for monetary base, then would you say that money is determining the price level or that the price level is determining money?

Nick, Regarding your quasi-monetarist comment: I agree that there is the possibility of disequilibrium in money markets but not in bond markets. I explain that with sticky prices; goods prices are sticky, and hence the currency market takes some time to adjust, whereas bond prices are flexible and hence the bond market adjusts instantly to a changed supply of bonds. Is that how you see things? (No obligation to respond if you are burned out with this post.)

Scott,

I predict Nick will answer yes and no. Yes, sticky goods and services prices create the unique potential for money market disequilibrium but not bond market disequilibrium. But no, that's not his whole story. Because even if bond markets were sticky (say the government fixed interest rates by law or that asset prices were actually sticky), an excess demand for bonds would not cause demand-recessions, because given a too-high rate people would give up on buying bonds and buy something else. So unless that turns into an excess demand for money, the bond market disequilibrium is non-contagious and thus non-recessionary. But with money, there is no such thing as buying something else.

In his QM "rant," he was talking about an excess supply of bonds, instead. So rates would be made somehow sticky at a too-low level. In this situation, the excess bonds would simply not be purchased, i.e. the government could not force an excess supply on the market at a stuck price. But with money, it can, because people will buy it even if they don't want to hold it at current prices (the price level). I know it is silly responding for Nick on Nick's blog.

2. No. A 12 month Tbill will be worthless today if we know the world will end in 11 months. But the expected PV of returns is still positive under uncertainty.

3. If the central bank is successfully targeting inflation at 2%, then by rational expectations everything in the bank's information set must be uncorrelated with inflation at the bank's forecasting horizon. See my old post on Milton Friedman's thermostat.
http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/12/milton-friedmans-thermostat.html

The two excerpts below sound incoherent:
"All probabilities are one or zero. If you will probably have to pay $1,000,000 in damages, liability of one million. If you might but will probably not, liability of zero
"
and

"Compare to tort law
All probabilities are one or zero. Someone sues you for ten million dollars. If probability of guilt is .4, you owe nothing. If .6, you owe ten million
"

Is the fellow for real ?

It would be better if lawyers knew nothing about "probabities" at all, rather than the stuff as delivered in the book, and instead relied on intuition.

Prices are introduced in one of the chapters and the wages and price movements shown in painstaking details. For example, how firms set prices. Not only that, a correct framework for converting nominal and real is given. Don't think anyone else has done that in such detail and accuracy.

"their definition of wealth is all wrong"

Ha! No, its what National Accountants use. For example the Federal Reserve's Z.1. So not Wrong :-)

"how aggregate variables behave in a deterministic system heading towards a steady state, isn’t it. No business cycles)!"

The variables move in a steady state in ordinary models but no such thing happens in complicated ones. In fact the interesting aspect is what happens between two states. As far as Business Cycles is concerned, Wynne Godley has had nice articles from the 90s-2008 about prospects for the US economy. In fact he really knew the difference between textbook models and complications from real policy.

"I don’t see that as radically superior to the neoclassical approach."

Well, neoclassical economics still lives in the exogenous money world isn't it ?

"I remember reading in some paper that stock flow consistency is a precondition of DSGE models, so it’s not like the principle is unique to PKE."

Any link ? The reason the accounting identity NAFA=PSBR+BP is emphasized is that NONE of the mainstream model take that into account. They are just mentioned in the passing (with incorrect interpretation) and how these flows affect stocks and how they feedback is far from achievable.

Nick Rowe: "Or rather: the orthodox position is that money is net wealth and no burden on future generations, but bonds are halfway between Barro and Buchanan. Half net wealth; half a burden on the future."

Hmmm. Isn't it the orthodox position that gov't deficits should be "financed" by bonds, rather than "printing money"? How so, when money is net wealth and no burden on the future?

"an excess demand for bonds would not cause demand-recessions, because given a too-high rate people would give up on buying bonds and buy something else. "

The point is not that there is an excess demand for bonds, but when people are leveraging -- so that more people are issuing bonds than repaying bonds -- then both the supply and demand curve for bonds shift to the right. When people are de-leveraging, then both curves shift to the left.

They may also shift in other ways, but the "horizontalist" view is about co-movements of supply and demand.

When there is aggregate de-leveraging, which could be becasue interest rates were hiked, reducing the desire to take out new debt, whereas the demand to repay debt is contractual, then aggregate demand for goods declines.

Similarly it is possible for everyone to increase leverage and to increase their spending on goods and services, causing aggregate demand to increase.

Desires to increase or decrease your debt burden can have the same effect as desires to hold more or less money, and to the degree that interest rates affect these desires, then you can talk about excessively high interest rates having the same effect as an excess demand for money. But it is not because the bond market is not clearing. It always clears, but it clears via both income and price adjustments.

Its not as simple as deflating nominals. There are correction terms which are stocks deflated by inflation loss. I don't think national accountants do it that way exactly, but I could be wrong.

This is important as in simple models, where a steady state is reached, the government deficit is not in balance but the real government budget balance is.

These things become important when one talks of issues such as government budget "constraint" as according to them in closed economy growth models, no discretionary attempts need to be made to hit a primary surplus whereas economists in general keep advising governments to make attempt to hit a primary surplus.

As in, these technicalities are important to get right when doing such an analysis. In open economy models, there are prices such as import/export, domestic prices etc ...

"Ramanan: "Well, neoclassical economics still lives in the exogenous money world isn't it ?"

No."

Nick, I really haven't seen any mainstream model which shows how money is created. For example if the money stock in the economy is 100 now and 120 in two years, what is the process which leads to this etc.

On the other hand G&L models explicitly achieve this by writing a demand-side model with special attachment to maintaining stock-flow consistency. Supply side is introduced slowly, one by one. I see it as a framework where one can play around. For example, what happens if wages change etc.

If I am allowed to go on a tangent in a discussion that is well above my head, I'd like to make some points on MMT vs. mainstream.
It must be somewhat puzzling and even frustrating for many economists to see the large following MMT blogs garner especially among non-economists like myself. They must think: look at this bunch of dilettantes who think they now understand economics by reading a couple of blog posts! Which is fair, I admit. What they miss is that the mainstream economics totally failed to educate the hoi polloi.
For example, Nick Rowe says: “So the growth of net private financial claims on the government must equal the growth of net government financial liabilities to the private sector. That's true in any model”
and Luis Enrique echoes with “the thing about how net financial assets are created/destroyed seems to me, when I translate it into terms I understand, as a perfectly unremarkable restatement of text book macro. But (some) MMTers portray it as an insight (we know how the monetary system really works!) so I must be missing something.”
Ha! Now, guys, please, step out of your ivory towers and do a survey on the street and find how many laymen understand this. I vouch that it’s somewhere in the vicinity of 0%. When MMT foot soldiers state the supposedly unremarkable truth of sectoral balances (Government Deficit = Non-Government Surplus) this is literally like bombshell for most people (and, frankly, looks like even a lot of economists don’t really understand that at a conscious level either.)
So, if you’re puzzled at the appeal of MMT, maybe some introspection is in order. I know that real economics is much more complicated than Warren’s book and MMT blogs. But you cannot eat ISLM curves. Economics is a profession that affects our wellbeing in a much more immediate way than, say, physics: it is OK if most people don’t understand the latter but it is not OK that most people don’t know that government going into surplus must mean the private sector goes into deficit. And for this mainstream economists have themselves to blame.

Srini, I should clarify that I focus on the non-interest bearing portion of the base. But even in that case the real demand for base money can vary sharply, as we saw in Japan. Still it's a useful framework for thinking about the price level. Consider the following: Australia has almost no national debt. Now assume they consider increasing the monetary base by 50% of current GDP. I'd guess the price level rises by at least 10 fold. Alternative 2 is to instead increase public debt by 50% of GDP, and leave the base roughly unchanged. The price level response would be vastly different in case 2, assuming Australia is not at the zero bound (obviously prices wouldn't rise anywhere near 10 fold). That's the sort of thought experiment I have in mind.

Just want to apologize for somewhat huffy and righteous tone of my comment - this wasn't really my intention (especially not towards any of the participants!). Thanks for the thread, Nick, maybe one day I'll re-read it and understand more than 10% :)

Ramanan, I find it hard to believe that modern mainstream models are stock-flow inconsistent. In the models, agents value stocks as a discounted sum of future flows, so they should be consistent by definition. Can you give an example of a standard general equilibrium model with open economies where the constraint you mention is violated?

IS/LM is not a modern mainstream model. I doubt more than a handful of papers using IS/LM have appeared in a top mainstream journal in twenty years. These days, most economists will see the model once, in an undergraduate macro class, and then never again. A modern mainstream macroeconomics model will be an infinite-horizon general-equilibrium model with utility-maximizing agents. These models have got to be stock-flow consistent just because agents will choose stocks in terms of the utility of the accompanying flows. A New Keynesian model will achieve Keynesian effects by assuming that prices are sticky. You can interpret parts of these models in terms of IS/LM (as Nick is wont to do), but if the full models aren't stock-flow consistent, I would be amazed.

I remember a recent Krugman post (maybe last 1-1 1/2 years) where he talks of the ISLM model and how it plays a role in the policy makers' minds.

I have good knowledge of the PKE literature but less of the New Keynesian ones. If you could point out some models I can then let you know. Its true that there are stocks and flows - that doesn't mean that stock flow consistency has been achieved.

For example http://www.columbia.edu/~mw2230/BOE.pdf by Michael Woodford, who is a leading NKEist has no talk of interest income on government bonds and also uses the IS/LM analysis - for example equation 1.10 in which money balances are functions of just flows.

Excellent comment. Dont sell yourself short just because you havent "studied" economics as much as some of the posters here. Sometimes the most insight comes from an outsider, the insiders are too wedded to their incomplete models.

Economics is quite simple. Much time is spent generating models which mainly serve to justify the current state of affairs which sees 99% of the world as moving closer and closer to being "owned" by 1% of the world. Economics could likely be summed up with this; If you are selling you want as high a price as you can get and if you are buying you want as low a price as you can get. Who has the power in the transaction wins. If you are the only buyer you win big and if you are the only seller you win big. We currently are moving towards the same small group of people being the primary seller and primary buyer in the same markets. Great for them, sucks for us..... and our "economists" are doing everything they can to provide cover for them.

MMT has allure because it states in no uncertain terms "It is never a money problem, since money is our invention we can create or destroy as much as WE decide we want to." Of course the critics act like thats a trivial statement and then go back out and yell about "budget problems" and lack of funding. The system we have was designed this way, it didnt just naturally occur. We can redesign it if we dont like the outcomes. We know what outcomes TPTB like by hearing what they ignore (private debt at over 300% of GDP) and which they say need to be addressed (public debt to US citizens at about 40% of GDP).

MMT says public debt can be used to pay off private debt...... so lets have lots more of it.... and make sure it goes to someone besides PIMCO.

Ramanan, that's definitely what I would call a modern model, so it makes a good example. But I don't understand why equation 1.10 makes the model stock-flow inconsistent. It's a behavioral rule -- in the context of the model, consumers aim to hold a certain stock of money. Maybe it's an implausible rule, but I don't see how that breaks stock-flow consistency.

Maybe I should say that the opposite of "consistency" is not inconsistency but something else.

Consumers aim to hold a certain stock of money but it also depends on the accumulated wealth. Not just income. While its not wrong to say it doesn't depend on wealth but only income, I believe one can find contradictions to the exclusion of stocks. The reason it may be difficult to see contradictions is that if there is some kind of equilibrium or a steady state one is talking of, a stock equilibrium/steady state is also a flow equilibrium/steady state and vice versa.

Equation 1.10 only holds in equilibrium. Equations 1.4-1.6 are the equations that hold out of equilibrium. These don't depend on wealth directly, but they depend on future consumption, which is affected by wealth.

Damn! My brain is going. Just remembered that my cursory "No" was about endogenous money, not stock-flow consistency!

Here's a better answer: the widely-used New Keynesian (I call them "Neo-Wicksellian") models that are very much the mainstream macro models assume the central bank has a nominal interest rate as its instrument. They are *very* "horizontalist", to use Post-Keynesian terminology. Usually, the stock of money does not even appear in the model. Implicitly, the stock of money is demand-determined. It's whatever people want to hold at the rate of interest set my the central bank. The implied money supply function is perfectly interest-elastic at that rate of interest. "Monetary policy" means some sort of Taylor Rule like reaction function for the central bank.

Now, you might say that those models are "New Keynesian" rather than "Neo-classical". OK. But they are very Neoclassical in most other ways. And they do represent the mainstream orthodoxy.

That doesn't mean there are no models with the central bank setting M rather than i. And many economists would argue that these are just two alternative ways of thinking about the central bank's response function, rather than a substantive difference. And that in neither case is either M or i truly exogenous, because the M or i set by the Bank responds endogenously to changing circumstances.

(Nowadays, only quasi-monetarist cranks like me insist that there is still an important sense in which money is exogenous, despite the Bank of Canada's perceived interest rate instrument.)

I believe, when SFC modelers say that they are stock-flow consistent, I mean that they try to include the flows and stocks of every big sector of the economy. They construct models using important flows and stocks like the ones published by national accountants (for example, the Federal Reserve's Z.1).

The point is not that that a NKE model A or model B is stock-flow inconsistent. The point is that there are simply at least a dozen flows and stocks which are not talked about together at the same time by the NKE.

Also, the attitude is of course completely different. Here is what Basil Moore has to say about PKE: (from his book "Shaking The Invisible Hand")

The centrality of Keynes’ principle of insufficient effective demand is the major theoretical distinction between post-Keynesian and mainstream New Keynesian, neoclassical, Monetarist, and New Classical macroeconomics. Post Keynesians insist that investment spending concerning the unknowable future is nondeterminate. Expectations are the key element driving changes in AD and driven by changes in “animal spirits.” The autonomy of investment spending from current income and output is the source of the openness and indeterminism of the Keynesian system.

(which shouldn't be surprising to Nick)

Coming back to Woodford's model, there are zillions of questions I may ask .. such as where is the household income, where is the wealth, where is the fiscal policy and the average tax rate ? .. as in if the government relaxes fiscal policy, it is generally agreed that it leads to an increase in demand .. but by how much ? and questions such as that ...

On the other hand, in PKE models such as G&L models, such questions can be asked .. there are no agents trying to maximise any utility function. The difference between the standard Keynesian multiplier analysis is that the latter is a one period model and stops exactly when things get interesting.

Here is a very simple model you may want to check to see what I am saying http://www.levyinstitute.org/pubs/wp_494.pdf ... at each period in time such as one quarter, the stocks and flow have some values and the future depends on these. Doesn't of course mean that the future is deterministic .. these are kind of "what if" models ... what happens if the government increases tax rates etc ...

I understand the distinction you are making ... one may want to say the central bank is reacting to inflationary pressures and hence the rate decisions are not exogenous.

On the other hand I am not sure about M. For it is just a residual.

To give an example ... and I think very few people actually understand this ... securitization is a huge industry in the US. The amount of loans in the non-bank liabilities is far higher than assets in the banks' balance sheets. If securitization hadn't been so popular, the money supply in the US would have been much much higher than what it is now. When a bank securitizes loans and sells it in the market, the amount of deposits in the banking system goes down because the non-banking private sector holds more securitized products in exchange for deposits. The money stock is just a residual of these transactions and events.

I believe that mainstream economists confuse money and demand. I have seen the Chartalists committing the same mistake! As in when they start giving the anti-analogies ("Oh that is Gold Standard paradigm")

I'm not saying that it's a good model, but just that's it's stock-flow consistent. Of all of the things wrong with mainstream models these days, at least they don't have that problem. Anyway, I personally find small, unrealistic models that address one question informative, as long as you don't lean on the unrealistic assumptions too much. Here I think Woodford is trying to address one specific question, which is whether a DSGE model can have non-Ricardian equivalence. There are bigger models that are intended to be more realistic and useful for policy, such as the Smets and Wouters model.

I think actually that the distance between the SFC literature and the New Keynesian literature is smaller than you might think. When someone writes down a NK model, they'll write down a complicated nonlinear thing that no one knows how to solve. Then they'll linearize it around a deterministic path, which gives them a linear stock-flow consistent model with rational expectations. Replace rational expectations with a more general behavioral rule, and the model would resemble an ordinary SFC model (I think).

Thanks for the links and I would need more links as well to see all possible kinds of NKE models on their idea of how the economy works.

I actually think that the distance is big and is quite dramatic - both at the narrative level as well as the modeling level (which in some sense is also narrative but using mathematical expressions).

The reason they may appear similar is that you may see households holding money and bonds... Plus there are similarities such as inclusion of depreciation of capital etc... And wages ... though in PKE, they are described as a class-struggle between workers and capitalists and there is negotiation on indexation to inflation.

But ... there is no talk on the paper you provided about the amount of bonds .. Bonds in SFC models, for example government bonds come via fiscal policy. In the simplest case, the government sets the expenditures and the tax rate and the deficit is endogenously decided by the private sector. and hence the stock of debt too. The important thing about SFC models are that they are monetary models in which financial variables - such as the ones provided by the Fed's Z.1 are really important. The stocks and flows of each sector are looked at etc (and other things such as unemployment).

The reason I am saying that there is a dramatic difference is the following. G&L had a model in 2006 on the Euro Zone - it had nothing about wages and inflation and simplest rule about monetary policy or taking interest rates on government debt as endogenous in other cases. http://cje.oxfordjournals.org/content/31/1/1.short

The Euro area balance of payments problem has a tremendous role to play in the whole dynamics. Its here that the three financial balances (NAFA=PSBR+BP, that is the net accumulation of financial assets of the private sector is equal to the public sector's deficit plus the current balance of payments). In the Euro Zone, the balance of payments constraints have become severe now. So simply by using the game around sectoral balances and a Keynesian demand-side story in mind but with some extra hard work on stock-flow consistency, the two authors (Godley&Lavoie) were able to capture the potential problems of the Euro Zone. So there is indeed a great difference in the kind of stories told by the two sides.

New Keynesianism is more of a modelling strategy than a specific story, so you could probably write down a model with the causality you have in mind in such a way that people would accept it as a New Keynesian model.

I side with Walt in his exchange with Ramanan. I just step in to ask in how far eq. 1.4-1.6 in Woodford's model hold out of equilibrium? In DSGE we have continuous market-clearing, that is, there is no out-of-equilibrium behavior. NEITHER individuals, NOR the system is in disequilibrium, NEVER.

Walt: "Equation 1.10 only holds in equilibrium. Equations 1.4-1.6 are the equations that hold out of equilibrium."

They hold out of equilibrium in the sense that they only follow from the agent's objective and the fact that the agent takes prices as exogenously given. If you could somehow take the agents into a laboratory and run experiments where you quoted prices to them and asked them for quantities, their responses would obey the equations.

amv: a minor point. A DSGE model with *Calvo pricing* (sticky prices that can only be changed at random times) isn't strictly speaking in continuous market clearing equilibrium, at least not in the normal sense of the term. Monopolistically competitive firms always wish they could sell more at the given (temporarily fixed) price, so in one sense there is always a sort of excess supply of output. Plus, they almost always wish they had a slightly higher or lower price. Those New Keynesian models are very Keynesian in that regard.

D'accord. The equations describe the rational response of agents to any price system, no matter if the price system is market clearing or not. General equilibrium analysis delegates such out-of-equilibrium behavior to stability analysis. However, taking stability for granted, or rather ensuring that stability exists by means of proper restrictions, the motion of macro-variables over time is described as an equilibrium process on individual as well as on aggregate level. I think there is no disagreement between us.

@ Nick Rowe

Sure, Calvo pricing implies a deviation from the optimal path, yet iff the interest-setting authority does not follow an optimal rule. This is the clue of the NK class of models: rigidities account for potential deviations from optimum, yet at the same time it allows the authority to impact real rates of interest and, thus, to control intertemporal consumption decisions. If the real rates are set in accordance with an optimal policy rule, the economy behaves exactly as if all prices were perfectly flexible. In this sense, there is continuous market clearing despite of price rigidities. Is this compatible to your view?